How to Creatively Make Deals Work During COVID-19
With the pandemic going full bore in many areas of the country, many real estate investors are asking whether or not it’s possible to find a “good deal,” and if so, they’re also looking for ways to make that deal work. Currently, buyers are looking for deals with depressed prices and discounts due to the pandemic, while sellers are looking to sell their multifamily properties without having to offer any substantial discounts. The reality is that when COVID just started, the market wasn’t a buyer’s market, nor a seller’s market, and some called it a “frozen market.” Today, we see more buyers and sellers engaged in deal making, and I am a firm believer that there are still good deals to be made, as there were pre-COVID-19, and there are also bad deals out there as well, just as there were pre-pandemic.
Some deals are openly marketed, while others are available off-market. If discounts are offered by a seller, they are generally minimal, often at 1% to 2%, for example. That amount generally isn’t enough to meet a buyer’s expectations, but it provides a talking point that can help to generate some interest. The good news is that you can still make a deal work during the COVID-19 pandemic if you think creatively.
So, what does it mean to work creatively when trying to make a real estate deal work during the pandemic? There are multiple ways you see and approach a deal in order to make them work. You can start by looking at the price. If sellers aren’t willing to reduce their price by a substantial amount, it may be that the deals are solid and resilient, which is something that you can’t say when looking at other asset classes like hotels or retail.
Of course, like any other investment there is risk with multifamily property investments, and risk has to be defined in order to determine whether you are buying at the right price. Fortunately, the risk isn’t as great as it was several months ago, when nobody knew what to expect after the pandemic hit. Now that we have a grasp of what the pandemic’s impact will be on the economy and on various classes of real estate investments, and there is less uncertainty, risk has been somewhat reduced.
If you see a deal that you think might work, and the price is close to what you believe is appropriate, there is a way to make the deal work if you really want it to happen. The key is to have the property in a strong location. Now is not the time to bet on a location or to be very aggressive. Instead, approach deals conservatively. It’s far more important to focus on the market’s median income, school districts, crime rate, and employment levels when looking at properties.
In addition, you should never compromise on your underwriting assumptions. You have specific metrics that you use when analyzing deals, whether those metrics are cash-on-cash, cap rates, projected rent growth or other analytics. Some investors tend to forgo their underwriting parameters in their desire to purchase a specific property, and they end up overpaying. For example, if you approach a deal now anticipating a 5% year over year rent growth, you’re going to be sadly disappointed. Due to COVID-19, a conservative rent growth of 0%-2% per year is far more realistic.
Another example is doing a value-add plan. Don’t expect to renovate 10 – 15 units at a time now, because you may not find enough tenants that can and will pay for an upgraded unit. Approach each deal and each aspect conservatively because now is not the time to be aggressive. Once the COVID-19 pandemic begins to resolve, things will change, but until then, be as conservative as possible. And even when you are conservative, there are ways to make deals work in today’s market.
3 Tactics That Can Help Make your Deal Work
1. Reallocate your Funds
During the pandemic, lenders have increased the reserve required to finance a property. Today, lenders have increased their required reserves, which amount to 9 to 12 months of debt payments. To cover that amount of money, some sponsors raise more capital. As an example, instead of raising $3M, they raise $3.5M, if $0.5M amounts to 12 months of debt payments. However, that could impact your returns because you’re raising more capital than the deal actually needs, and may dilute your investors.
One creative way that I discovered to make the deal work is to use some of your capital expenditure (CapEx) budget to pay the debt, assuming you don’t have an immediate need of 100% of the budget. For example, if you’ve budgeted $750,000 for capital expenditures, which might include renovating units, improving landscaping and new paint, etc., you can reallocate some of that money and use it for your escrow requirement. After 9 to 12 months you’ll have the money back in your CapEx budget because the lender will be taking your funds from the escrow account. This way, you are not diluting investors and don’t need to raise more than you need in the 12 months after closing. Just be sure you’re not using 100% of your CapEx budget because you’ll always have some unexpected expenses.
2. Adjust your Fees and Splits
Another creative way to make a deal work is to consider reducing your fees. For example, instead of taking a 2% acquisition fee, you can charge only 1.75%, so investors can receive a yearly return that makes sense. You’ll still be making money on the deal, albeit slightly less. However, you must remember that 1.75% of some dollar amount is far better than receiving 2% of zero dollars, so if the deal doesn’t make sense with a 2% acquisition fee because investors make only 5% cash on cash, it might be better for you to lower your fees so the deal is lucrative for your investors. It’s the same with equity splits. Instead of having a 70-30 equity split, where 70% of the income goes to investors and 30% goes to the sponsor, you could have an 80-20 equity split, which reduces your income. While you will be making less money on your deal, you will at least have a deal that works.
You can also decide on the split at the time of sale. You can keep the same equity split or change it – it’s up to you as a sponsor. Just play around with the numbers to make sure that the deal works for everyone. The point is to not be fixated on specific equity splits or fees, because with some adjustments, you’ll be able to make any deal work if you’re willing to be flexible.
3. Getting a Collection Guarantee
When you’re underwriting a deal and you approach it conservatively, you take into consideration that rent collections may drop in the next 6 to 12 months. The reason is simple: as unemployment increases around the country, more and more people are not going to be able to pay their rent. However, if you approach the seller and ask to look at the average rent collections over the past 3 months, say for example, the 3-month average was $100,000, you can require that the seller provide you with a collection guarantee.
With collection guarantee, if rent collections fall below a certain threshold (in our example, $100,000 average amount over the next 10 months), then the seller would pay you for the difference between your actual rent collections and a certain threshold ($100,000 3-month average in our example). This approach was applied during and after the great recession of 2008, and it helped make many deals work. The seller can put the money in escrow, and it will be released to the buyer after a pre-determined time period.
Many investors are wondering if it’s possible to make real estate deals work during the pandemic. The answer is “yes,” if you work creatively. You have to remember that there were both good and bad deals available prior to the pandemic, as there are now. But if you come across a true good deal, then there are some key ways to make the deal work.
First, reallocate your funds. Lenders now require borrowers to place 9 to 12-months of debt payments in escrow at closing. Some sponsors borrow additional money to cover these costs, but a more creative approach would be to reallocate funds from a CapEx budget to cover them. The money will end up back in the CapEx budget after 9 months.
Another approach to make a deal work is to reduce your fees and equity splits. This provides more income to the investors, and while it may reduce your income on the deal you have to realize that some money is better than not having a deal at all. Having the seller provide you with a collection guarantee is another creative way to make your deal work. This guarantee would require the seller to pay you the difference between your actual rent collections and a pre-determined threshold. It was widely used during the great recession of 2008 and has helped make many deals work. The more creative you are, the better chance you’ll have of getting your deal through.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
Ellie is the host of REady2Scale , a podcast that focuses on the "APS" of real estate: Asset, Process, and Strategy. Each episode discusses how investors can scale their real estate portfolio and/or businesses.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.